Key Metrics of Auto Retail: Floor Plan Interest Expense Per Vehicle

Economic growth slowed in the first part of this year and the adjustment in the housing sector is ongoing. Nevertheless, the economy seems likely to expand at a moderate pace over coming quarters.

Core inflation remains somewhat elevated. Although inflation pressures seem likely to moderate over time, the high level of resource utilization has the potential to sustain those pressures.

In these circumstances, the Committee's predominant policy concern remains the risk that inflation will fail to moderate as expected. Future policy adjustments will depend on the evolution of the outlook for both inflation and economic growth, as implied by incoming information.

Federal Open Market Committee Statement after leaving the over night lending rate to banks at 5.25% (May 9, 2007)

Why I still think investors and industry participants should be prepared for higher interest rates down the road
So the Federal Reserve Board decided to hold interest rates steady. I am not an economist. But I will continue to point out that no one seems able to measure money supply (too much of it is what causes inflation). However, one of the best symptoms of excess money supply is when you see tangible assets (like commodity prices) rising (to paraphrase a comment made by First Trust's Chief Economist Brian Wesbury on CNBC several months ago).

And I don't want people to forget that 5 years ago the U.S. dollar would get me 1.10 Euros. Today it will get me 0.74. This means I can only get about sixty-seven cents on every dollar I would convert in Europe just 5 years ago. So people can measure inflation in all sorts of ways. But the bottom line is that my dollar just doesn't buy what it used to.

Importantly what this means for investors and auto retail industry participants is that they need to be prepared for a long term trend of higher rates. Sure the Fed may lower rates temporarily because of a slow down in the economy. But if foreign dudes are going to continue to invest in U.S. debt (where foreign investors are estimated to represent a little more than $4 out of every $10 in U.S. public debt), at some point they will demand a higher return to compensate for the lower value of their investment when they convert it back to their currency.

But you and I, and the management teams of the auto retail companies can not control interest rates. As I have discussed before, no matter how good of a planner a government or business may be, they can not match up society's resources perfectly with the wants and needs of its citizens. There are inevitably "imbalances" that occur. The ebbs and flows you hear me often refer to. And most of the time I try to focus your attention away from these ebbs and flows. Over the really long run I don't think "buying on the come" of some flow or avoiding an investment because of some impending ebb determines superior returns.

The "flows" or good times often hide inefficiencies that pop up in a business model. The "ebbs" often times expose those inefficiencies. Sure the flows are more fun than the ebbs. But I have yet to meet an "investment guru" that has been consistently right in trying to anticipate ebbs and flows over a 10 year period. Instead most investors end up "chasing returns."

Real, sustainable and long term returns I think come from companies that provide the best value proposition in a market. If you invest in the companies that are best at filling some need (service, price, whatever value customers base their decision on), the company is likely to generate superior returns. And if you paid an appropriate price for that future return, you should be handsomely rewarded.

So what I want you to focus on (ebb or flow) is on measurements that help in assessing how effective a company is in filling a need in society. The 50 year low interest rates the auto retail industry benefited from a couple years ago therefore hid an inefficiency in the system; excessive inventories.

But what really matters is measuring a company's ability to manage through the ebbs and flows. And so floor plan interest expense per vehicle becomes a good metric.

As a result, a measurement tool (albeit not making the seven key metrics) I like to look at is floor plan interest expense per vehicle. Keep in mind, sometimes when management teams are between capital allocation decisions, particularly debt refinancing, they sometimes "park cash" by paying down floor plan debt levels, which can skew these figures.

What the heck do I mean by "park cash?" Well, imagine you are the CFO of one of these dealer groups and you see an opportunity in the market to refinance $200 million worth of debt at say a fixed rate of 7% while right now you are paying 11% on $200 million in bonds. But your call date on the 11% bonds doesn't come up for another 6 months.

You are probably not best serving your stakeholders by trying to wait out the six months and hope that the favorable interest rate environment remains. Now two years? You might need to do some more number crunching. But when you get that close to the call date, sometimes it is just better to take the opportunity when it comes.

So you issue the 7% bonds, and have to wait 6 months with $200 million in cash that you just received to buy back the 11% bonds. You could put the $200 million in a money market account or short term government bond, or you could pay down your floor plan borrowings. And apparently it is a better return paying down the floor plan debt versus putting it in a money market or short term government bond. So it is cases like this that can on rare occasion cause abnormal movement in floor plan interest expense per vehicle.

The abnormal "parking cash" phenomenon aside, for the most part I like to focus in on the year over year and sequential movements in floor plan interest expense per vehicle. And even more importantly the change in a company's floor plan interest expense per vehicle versus industry-wide changes in inventories. This is important because I base my forecast for floor plan interest expense on these industry inventory movements. So if the company is moving out of sync with the industry, it tells me something might be going on. Like I said it could be as simple as a company parking cash. It could mean the company is taking advantage or making a bet on some incentive program expected or promised from a manufacturer. But at the end of the day, it really is a measurement of just how effective the company is managing its inventory.

For those analysts that simply focus on the reported days supply figures by the company management teams, I would encourage you to add this metric to your arsenal. Because the reported days supply figure is usually just what the company ended with (in inventory) in March divided by the daily selling rate (total vehicles sold divided by number of selling days in March). So frankly I don't think the days supply figure gives you as good of a picture of the company's inventory management during the quarter as floor plan interest expense per vehicle.

Now before you get to the tables below, let me give you some industry background and explanation of the figures you are looking at.

The first set of tables simply show you the companies floor plan interest expense in 1) the first quarter of 2007 (1Q07), 2) first quarter of 2006 (1Q06), and 3) fourth quarter of 2006. So Asbury (ABG) for example, had $11.2 million in floor plan interest expense in the first quarter of 2007, which divided by the 40,917 vehicles they retailed in the first quarter means they spent roughly $274 per vehicle (new and used) in floor plan interest expense per vehicle.

The second set of tables show you the year over year change from 1Q07 versus 1Q06 and sequential change (so 1Q07 versus 4Q06). The percentage changes themselves are somewhat helpful. So Asbury's inventory expense per vehicle was up almost 21% versus the first quarter of 2006. But down 3% sequentially (from the fourth quarter of 2006). In part, the higher year over year floor plan interest expense at Asbury is due to slightly higher interest rates. But it is also due to roughly 26% of their business being Honda (HMC), and Honda dealers (industry-wide) experiencing an 11.5% increase in dealer inventories.

And while I can't walk you through every company and their brand exposure and inventory movement, my point is that what you want to look at is how these companies did versus the industry averages.

Industry-wide (according to Automotive News) there were about 3.57 million vehicles sitting on dealer lots at the end of March 2007 (ok, technically April 1st). So if I take the ending inventory values for January (3.51 million), February (3.57 million), and March, and divide by 3 (months), I come up with a kind of "unweighted" average inventory for dealers of 3.55 million in the first three months of 2007 (first quarter).

The industry-wide first quarter 2007 dealer inventories were down about 5% from the unweighted average of dealer inventories I calculated for the first quarter of 2006. So in Asbury's case, they had floor plan interest expense per vehicle up nearly 21%, when industry-wide inventories were down 5% (year over year). This is why you heard me articulate my concerns about their Honda inventories after the first quarter conference call.

My concerns aside, industry-wide dealer inventories actually increased 2.3% in the first quarter of 2007 from the fourth quarter of 2006. While Asbury's floor plan interest expense per vehicle (sequentially from the fourth quarter of 2006 to the first quarter of 2007) declined almost 3%. So they are probably getting a better sell through and may suggest Asbury's bet to add inventories will pay off as they head into the Spring/Summer selling season. It still leaves me nervous. But hopefully the example of Asbury (taken only because they appeared first alphabetically) helps put the numbers you see below in a little better perspective/context.

Floor plan interest expense per vehicle

Source: company reports, AutoRetailStocks

Floor plan interest expense % change per vehicle

Source: company reports, AutoRetailStocks

Comerica Affordability Index: 24.7 weeks of your income to buy a vehicle
I don't know how to measure "net price" of vehicles. But one statistic I try to keep an eye on is the Comerica Affordability index. Basically the index takes a family's income and divides it by the average cost of buying a vehicle (including financing costs). It is the "cost of buying the vehicle" we all struggle in measuring given how creative all of the various customer and dealer incentive programs have become.

Keeping the limitations in mind, the folks at Comerica (headed up by Chief Economist Dana Johnson), estimate in January, February and March of 2007 (first quarter), it took the average family in America 24.7 weeks of their income (technically median household income) to buy a car.

Or another way of saying it, if you fell right smack dab in the middle of all incomes earned in the United States and bought a car, and then didn't pay any other bills or taxes, and just took your entire paycheck and put it towards the car payment, it would take you almost 25 weeks before you were done paying it off. So almost half a year!

Now the general sense I got from listening to the automaker and public dealer conference calls was that March saved the day. And a lot of the strength in March came from some incentive programs, particularly dealer bonus programs that caused a big push at the end of the month/quarter. This is what kept retail sales relatively flat versus a year ago in the first quarter (1Q07 versus 1Q06). And when you look at the Comerica affordability index, it tends to support this theory. Ms. Johnson indicates the 24.7 weeks is actually down 0.5 weeks from the first quarter of 2006, and down 1.5 weeks (from 26.2 weeks) in the fourth quarter of 2006. So while the automakers appropriately reduced unprofitable sales to rental car companies, they still stimulated retail buying a bit at the end of the quarter.

The weakness in April from what I could tell seemed to be because the automakers didn't follow up from the March boost with any new real incentive programs. Now I also heard on a number of other calls like O'Reilly Auto Parts that April sales were weak. So there may have been other factors (weather, housing, whatever), adding to the weakness.

But you and I aren't really interested in these ebbs and flows. As I have long stated this summer is going to be a tremendous test because every other year (since 2001) the automakers have stepped in with some big incentive program (i.e. 0% financing, employee discount). 2007 is the year then for some novel promotion. This year, so far, however, the automakers seem to be holding the line pretty well (despite the somewhat aggressive push in March).

If the automakers can continue to "hold the line" this summer and not cave in to "demand creation" while the results at the public dealers will probably not be great, it could set the stage for massive consolidation in years to come. If the automakers capitulate and come out with some aggressive programs, it will be good for the public dealers and their stock prices in the near term, but once again, will likely mean another several years of these "ebbs and flows" as the industry works toward balancing supply with the true underlying demand. So don't go anywhere too far this summer on your vacation, because I think we are going to learn a lot about the industry in the coming few months.